by on Friday, October 24th, 2014 | Comments Off on Lower Credit Standards: Economic Boost or Bust?

We’ve always been told that success depends on setting high standards.

Lowering your standards, so the conventional wisdom goes, leads to accepting low quality and ultimately bad outcomes. But in a bid to offset a sluggish recovery, the US government is advocating just that, with proposals on several fronts to lower borrowing standards to make credit available to more people and stimulate consumer activity.

Risky Lending Led to Collapse

The flip flop on borrowing standards comes in the aftermath of the much publicized housing collapse of 2008, when lax lending standards and greedy lenders put complicated mortgages in the hands o unprepared home buyers. After many of those borrowers found themselves underwater or in default, the housing market collapsed.

After that crash sent ripples through the entire economy, the US Department of Justice and a number of state-level attorneys and legislators took at hard look at those wild and wooly lending practices and found many of the perpetrators guilty of outright fraud or grossly misleading borrowers – or both.

Investigations and lawsuits followed, charging the nation’s major banks with a variety of criminal and civil misdeeds. In an effort to hold lenders accountable, the Dodd Frank Act of 2010 and similar legislation imposed new and stiffer regulations on lenders and new protections for unwary borrowers.

Tighter Standards on the Rebound

Mortgage lending, as the leading culprit in the crash, fell under the greatest scrutiny. The Qualified Mortgage Rule was implemented in early 2014 – a standard for mortgage lending put in place by the Consumer Financial Protection Bureau, an outgrowth of Dodd Frank. It mandated that for a lender to have some protection from prosecution for bad loans, its loans had to be held to higher standards in terms of creditworthiness, debt to income ratio and down payments.

The goal, regulators claimed, was to prevent unqualified borrowers – those with lower credit scores and lower incomes in general – from taking out mortgages and other big loans they couldn’t handle. That way, the toxic combination of risky loans to unprepared borrowers couldn’t trigger another massive collapse.

For a while that plan seemed to be working. In 2014, the Federal Reserve hauled back on its ongoing stimulus plan. Interest rates stayed low. Employment picked up a bit and home prices started to rise. But in the midst of these promising signs, another trend emerged.

Fewer mortgages were being approved. Home prices were beginning to rise, housing starts were up – but people weren’t buying. In other areas of the economy, too, things were slowing down. A soft job market meant that people couldn’t buy homes or make other big purchases – a trend that was accentuated by the massive burden of student loan carried by many new college graduates.

Lower Standards to Stimulate Buying?

Worried economists suggested the slowdown in consumer activity could signal another collapse, this one ironically triggered by the efforts made to prevent it. Faced with that possibility, government decision makers opted to accommodate a disheartening status quo.

The old Serenity prayer asks for grace to accept the things that can’t be changed, and the Federal Reserve and lawmakers on both sides of the aisle had to admit that in a rocky economy, credit scores weren’t going to improve much. And the fact that a growing number of middle and lower class consumers had no borrowing power all but guaranteed a slowdown in economic growth.

So the Federal Reserve mad the unprecedented move in the spring of 2014 to request the Fair Isaac Corporation, originators of the most powerful credit scoring system in the country, to adjust FICO scores downward. That would reduce the impact of things like foreclosures and missed payments on an individual’s credit report, and allow more people with a slightly iffy credit history – or none at all – to meet the minimum standards for qualifying for a loan.

That move comes as more lenders have been choosing independently to work with borrowers who have been through foreclosures due to the collapse, or who have struggled with being “underwater” on their mortgages. And now, the Federal Housing Finance Agency, the regulator that oversees government megalenders Fannie Mae and Freddie Mac, is pushing for new agreements to reduce the minimum down payment requirement for a home loan to just 3 percent along with loosening credit standards for loans handled by the two agencies.

That, say FHFA officials, would make it easier for lower income borrowers to get loans to buy houses and other major consumer goods, which would jump start the housing industry and other sectors – and that in turn would get the economy humming again.

Another Collapse on the Horizon? Maybe

But critics of these moves point out that lowering standards is more of an “if you can’t beat ‘em, join ‘em” game that sets up conditions for another collapse. Rather than simply opening the doors to less qualified borrowers, they argue, consumer agencies and the government should focus on efforts to improve borrowers’ ability to manage credit and earn more.

But regulators from FHFA and other bodies point out that the reasons for so many borrowers’ credit and income problems stem from the original collapse – and adjusting standards downward is just an acknowledgement of that new reality. Helping these individuals to get back on track helps the economy as a whole, they argue – and that’s a boost for everyone.

Will lowered borrowing standards mean a boost, or a bust, for the economic recovery? It’s far too soon to tell. But financial experts also point out that it may be a slippery slope with no way back. But with lessons from the past clear and recent, short-term relief for some could mean long-term benefits for everyone. (Top image: Flickr/EGlobe Travel)